Risk assets have edged higher, buoyed in part by robust corporate earnings. But President Trump’s decision to remove Governor Cook by tweet — and his wider assault on the Fed’s independence to lower short-term interest rates — has contributed to the ongoing sell-off in long-term government bonds.
Other forces matter too, not least a burst of issuance after the summer lull. Still, the attacks are serious. That puts the Fed in a hard place. Tariffs and tighter migration policies are already dampening growth and pushing prices up, a complicated situation for a central bank. A rise in inflation expectations is the last thing the Fed wants. Unfortunately, most measures have been climbing in recent months.
We have nudged up our US inflation forecast for 2026, since tariff-driven price pressures now look likely to last longer. That should not stop the Fed from cutting rates, though it will move cautiously. The policy mix still argues for steeper yield curves, a weaker dollar and a supportive backdrop for gold over the next 18 months.
US policy mix clouds outlook
The US administration has renewed its attacks on the Fed’s independence. Investors, in turn, have priced in further rate cuts and somewhat higher long-term inflation. Other forces are also at work. July’s jobs report pointed to a weaker labour market than expected, prompting Chair Jerome Powell to hint at a September rate cut at his Jackson Hole speech.
Recent data has been more encouraging. Policy uncertainty has eased since its April peak, though it remains historically high, helping business and consumer confidence to strengthen. Consumer spending and AI-related capex spending were revised up in the second quarter. Core capital goods orders were strong in July, and the ISM manufacturing new orders component showed new orders returning to expansion in August for the first time in six months. Payrolls in August/September are likely to exceed what we estimate to be the current breakeven pace of 60,000 jobs a month – the level needed to stabilise unemployment – suggesting the jobless rate could even fall to 4.1%.
The administration’s policy mix continues to cloud the outlook. It delivers a stag-flationary jolt, while reshaping the global economy. Migration curbs are already shrinking the workforce and could reduce potential growth by 0.1 this year and 0.3 percentage points next year. High tariffs on many imported inputs are squeezing production capacity, leaving the world economy more fragmented and less efficient.
So far, American firms have absorbed much of the tariff cost in their margins, but they cannot do so indefinitely. More tariff passthrough to prices is likely in the months ahead. Core PCE inflation – the Fed’s preferred gauge – is expected to stay a bit above 3% until mid-2026. We have nudged up our CPI forecast for that year to 2.7%, from 2.5%.
Fed to cut rates gradually
Should the Fed cut at all with inflation moving in the wrong direction? Its dual mandate compels it to weigh risks to employment. As Powell noted in Jackson Hole, the labour market looks balanced because demand and supply have declined roughly in tandem. But the risk is that the unemployment rate picks up if supply stabilises and demand continues to weaken.
Yet in our view, supply is likely to fall further with the deportation of illegal migrants gathering pace. By our estimates, monthly breakeven payrolls could drop to 40,000 by year-end, and even lower if participation slips – a clear possibility given that many undocumented workers work in the care industry.
Governor Waller has recently argued that supply constraints do not absolve the Fed from managing demand. True enough. But stoking demand, which appears to have stabilised, when supply is falling risks fuelling inflation through a tighter labour market and stronger wage bargaining, at a time when tariffs are already raising prices. Political attacks on the Fed only add to the danger by nudging up inflation expectations.
The committee is well aware of these trade-offs. As a result, rate cuts are expected only gradually, moving towards a neutral stance. Our forecast remains at two rate cuts this year and two next, leaving the upper bound of the policy rate at 3.5%, our estimate of neutral.
